My memory doesn’t always serve me well, but I recall reading a quote years ago that went something like, “Why pan for flakes when there’s a nugget sitting in plain sight?” Well, I’ve been interested in IBM for quite some time. However, in my perpetual search for often obscure bargains, I probably spend too much time panning for flakes.
This weekend I finally got around to reading every relevant IBM document I could get my hands on. They were plentiful because IBM is such a big company. Then I found out who the key players are, what their interests are, and ran through my 96-point checklist to help understand all of the risks, as best as I could. Perhaps my vision is no better than my memory, but IBM looks like a nugget in plain sight.
Thanks to the wonder of search engines, I was able to find out quite a bit of helpful information about CEO Samuel Palmisano. His paper trail checked out. Palmisano understands that in the highly competitive technology area, the winners will be the ones that add the most value to their customers.
The proliferation of vast amounts of information makes virtually everything measurable in real-time now. It will never be perfect as long as we are imperfect, but we’re much more efficient now than we’ve ever been. Customers will continue to demand measurable results in the IT industry. And Palmisano understands that it’s hard to add value in commodity-type businesses.
There are still plenty of people who think of IBM as the big hardware firm. As part of Palmisano’s vision, commodity-type businesses such as hardware were deemphasized or divested. Essentially, IBM now manages very important pieces of the global IT infrastructure using its own software, products, and service offerings. Services and software businesses are particularly attractive because they require very little capital and they produce highly predictable streams of recurring free cash flows. You will have a hard time finding another investment that is more diversified by exposure to industries, geography, currencies and technologies.
A quick glance at 15-year operating results are really impressive. And the past three to five years are especially noteworthy. IBM correctly and successfully transformed into a global IT service company and now competitors are scrambling to catch up.
Many companies are reporting impressive numbers in the first quarter of 2010—less impressive considering year-over-year comparisons made against the depths of the recession. IBM barely skipped a beat in the panic of 2008-09. And in the first quarter of 2010, they are showing some impressive growth on top of their solid comparisons.
There are four basic components of total return for stocks. In order of importance, they are: 1) Purchase price; 2) Future free cash flows (FCF); 3) The reinvestment rate of those FCFs, both retained and paid out; and 4) The sale price. The only one investors can control is purchase price. Luckily, that’s the most important one for investors.
Depending on how conservatively you want to treat IBM’s financing working capital, a recent share price around $122 provides a 9% to 10.5% free cash flow yield. The risk of significantly lower future free cash flows is fairly low and the probability of sustainable, higher per-share future free cash flows is extremely high. Take the free cash flow yields and apply a fairly wide, but conservative range of outcomes for the important things that we can’t control: future free cash flows, returns on invested capital, and interest rates. I won’t talk specifically about my fair value range, but common sense tells me that a 9% yield with growing coupons ain't that bad.
How could this be available in one of the most widely recognized names of all time? It is possible that IBM is misunderstood. It is also possible that people are bored because the stock has gone nowhere in a decade (never mind that per share earnings have almost tripled during this uneventful time). Investors will find it difficult to get a higher quality business, with that kind of free cash flow yield and a strong balance sheet. “Backlogs” are beginning to show some weakness, but they are still very strong overall.
As governments, companies, institutions and people worldwide continue to benefit from the efficiencies of global IT integration, IBM is likely to enjoy a nice tailwind because its business model is tailored to benefit from that exact movement. The operating results offer supporting evidence. The CEO is very smart and has a very large interest in a higher future stock price. The company has approval to repurchase $10 billion in company stock and is likely to request approval for more soon. Dividends continue to rise as well.
There aren’t too many reasons not to own it. Investors will find it difficult to get a higher risk-adjusted spread over inflation-adjusted, long-term U.S. Treasury rates. In fact, I will put my money where my mouth is and take a position. For further disclosure, IBM did receive a positive review in my full report.
Looking at IBM’s chart is painful because I didn’t have a close eye on it during the crisis, when it traded all the way down to $70. But the future doesn’t care where the past has been. At current prices, it looks like an investor can get IBM’s future for free.
Disclosure: No current positions, but will purchase shares of IBM immediately following publication.